Months ago, I (really Steve Waldman of Interfluidity) proposed a possible reason people were freaking out over inflation: The returns to cash after accounting for BOTH short term interest rates and inflation were negative for the first time in 30 years. We were seeing actual debasement for holders of cash.

However, there is another reason to be worried about inflation. Holders of existing assets would get wiped out if inflation were to rise to 5%., because discount rates on assets would cause asset values to tumble.

Assets are valued by using a discount rate. The simplest way to value an asset is to assume it has infinite life, and then divide the cash flows generated by some discount rate. If we use $100 for the cash flows, and then assume the discount rate is 3%, the value spit out by this equation is $3,333.33.

This is essentially the model the fed uses to figure out a *fair* value for the stock market. The fed model was to take the 10 year rate, and divide Earnings yield by the 10 year to get a value.

If inflation were to go up to say 5% per year, it’s entirely possible the 10 year yield would go up to 7%. What would this do to equity values? The value of that same $100 is only 1,428.57 using .07 as the divisor.

Assets would fall in value about 60% if inflation was to actually hit 5%. I can see why many people would be very worried about inflation, given that nearly every asset in the U.S. would fall in value by 60%.

Can you imagine what would happen to our housing market and economy if we saw inflation hit 5%?

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4 Comments on "Why are You Freaking Out Over Inflation When We Don’t have Inflation? Part II"

Well, dang. My html-fu is weak. Here is a link:

http://research.stlouisfed.org/fred2/graph/?g=AeL

That’s an interesting point Mike but is inflation the crusher here or rising interest rates? People determine how much house they pay by looking at monthly payments (so $8.3 x 12 to get to your $100– but lets first multiply everything by 100 so it don’t sound like its 1925).

Say a buyer can budget $830 a month on an interest only mortgage, whether the rate is 3% or 7%, its still $830. The difference is a 3% rate gets you a $333,300 house and a 7% rate gets you a $142,857 house. That can’t be good for home prices. I think Congress should lock the risk free rate where it is (or to take it to the next level, Mosler suggests dropping it to 0% and stop issuing anything longer than 3 month T-bills), and put it on the Fed to use capital controls and other non-rate tools. Fiscal policy is very important too but lets not give the pols too much to think about all at once.

One happy result from Congress locking rates would be it effortlessly cut trillions of dollars from CBO’s 10 year deficit estimates because of the sudden drop in projected net interest. Net interest is the low lying fruit of the federal budget, its 10 year cost is estimated at $5 trillion. To my mind that’s an awful big prize sitting there for the first political party to figure out they can cart it off for their own political purposes. But I digress.

For fun, here’s a graph of monthly interest-only (using 30-year mortgage rate)payment on the median-price US home. The blue line is actual dollars, the red line is in 2012 dollars.

I guess it partly depends on whether interest rates did increase in line with inflation. In the late 1940s and early 1950s wasn’t there a sustained period of negative real rates (both short term rates and long term rates)?